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5.12.19 12 6.7.2023 NEWS Daniel Gros Daniel Gros is Professor of Practice and Director of the Institute for European Policymaking, Bocconi University OPINION Why US 'dollar doomsayers' could be wrong about its imminent demise T he position of the US dol- lar in the global league table of foreign exchange reserves held by other countries is closely watched. Every slight fall in its share is interpreted as confirmation of its imminent de- mise as the preferred global cur- rency for financial transactions. e recent drama surrounding negotiations about raising the limit on US federal government debt has only fuelled these pre- dictions by "dollar doomsayers", who believe repeated crises over the US government's borrowing limit weakens the country's per- ceived stability internationally. But the real foundation of its dominance is global trade – and it would be very complicated to turn the tide of these many transactions away from the US dollar. e international role of a global currency in financial markets is ultimately based on its use in non-financial transac- tions, especially as what's called an "invoicing currency" in trade. is is the currency in which a company charges its customers. Global network of supply and trade Modern trade can involve many financial transactions. Today's supply chains often see goods shipped across several borders, and that's after they are produced using a combination of intermediate inputs, usually from different countries. Suppliers may also only get paid after delivery, meaning they have to finance produc- tion beforehand. Obtaining this financing in the currency in which they invoice makes trade easier and more cost effective. In fact, it would be very incon- venient for all participants in a value chain if the invoicing and financing of each element of the chain happened in a differ- ent currency. Similarly, if most trade is invoiced and financed in one currency (the US dol- lar at present), even banks and firms outside the US have an in- centive to denominate and set- tle financial transactions in that currency. is status quo becomes dif- ficult to change because no in- dividual organisation along the chain has an incentive to switch currencies if others aren't doing the same. is is why the US dollar is the most widely used currency in third-country transactions – those that don't even involve the US. In such situations it's called a vehicle currency. e euro is used mainly in the vicinity of Europe, whereas the US dollar is widely used in international trade among Asian countries. Researchers call this the domi- nant currency paradigm. e convenience of using the US dollar, even outside its home country, is further buttressed by the openness and size of US fi- nancial markets. ey make up 36% of the world's total or five times more than the euro area's markets. Most trade-related fi- nancial transactions involve the use of short-term credit, like using a credit card to buy some- thing. As a result, the banking systems of many countries must then be at least partially based on the dollar so they can pro- vide this short-term credit. And so, these banks need to in- vest in the US financial markets to refinance themselves in dol- lars. ey can then provide this to their clients as dollar-based short-term loans. It's fair to say, then, that the US dollar has not become the pre- mier global currency only be- cause of US efforts to foster its use internationally. It will also continue to dominate as long as private organisations engaged in international trade and fi- nance find it the most conven- ient currency to use. What could knock the US dollar off its perch? Some governments such as that of China might try to offer alternatives to the US dollar, but they are unlikely to succeed. Government-to-government transactions, for example for crude oil between China and Saudi Arabia, could be denom- inated in yuan. But then the Saudi government would have to find something to do with the Chinese currency it receives. Some could be used to pay for imports from China, but Saudi Arabia imports a lot less from China (about US$30 billion) than it exports (about US$49 billion) to the country. e US$600 billion Public Investment Fund (PIF), Saudi Arabia's sovereign wealth fund, could of course use the yuan to invest in China. But this is diffi- cult on a large scale because Chi- nese currency remains only par- tially "convertible". is means that the Chinese authorities still control many transactions in and out of China, so that the PIF might not be able to use its yuan funds as and when it needs them. Even without convertibil- ity restrictions, few private in- vestors, and even fewer western investment funds, would be keen to put a lot of money into Chi- na if they are at the mercy of the Communist party. China is of course the country with the strongest political mo- tives to challenge the hegem- ony of the US dollar. A natural first step would be for China to diversify its foreign exchange reserves away from the US by investing in other countries. But this is easier said than done. ere are few opportunities to invest hundreds or thousands of billions of dollars outside of the US. Figures from the Bank of International Settlements show that the euro area bond market – a place for investors to finance loans to Euro area companies and governments – is worth less than one third of that of the US. Also, in any big crisis, other major OECD economies like Europe and Japan are more likely to side with the US than China – making such a decision is even easier when they are us- ing US dollars for trade. It was said that states accounting for one half of the global popula- tion refused to condemn Rus- sia's invasion of Ukraine, but this half does not account for a large share of global financial markets. Similarly, it shouldn't come as a surprise that democracies domi- nate the world financially. Com- panies and financial markets re- quire trust and a well-established rule of law. Non-democratic regimes have no basis for estab- lishing the rule of law and every investor is ultimately subject to the whims of the ruler. When it comes to global trade, currency use is underpinned by a self-reinforcing network of transactions. Because of this, and the size of the US financial market, the dollar's dominant position remains something for the US to lose rather for others to gain. The real foundation of the dollar's dominance is global trade

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